1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 26 Investment and Financial Intermediation

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment An investment is an action that costs today but provides benefits in the future.An investment is an action that costs today but provides benefits in the future.

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment and Financial Intermediation Financial institutions play a role in making it easier for an economy to invest.Financial institutions play a role in making it easier for an economy to invest. Financial intermediaries are organizations that receive funds from savers and channel those funds to investors.Financial intermediaries are organizations that receive funds from savers and channel those funds to investors.

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment: A Plunge Into the Unknown Uncertainty is an important aspect of investment. There is a trade-off between costs today and uncertain future gains.Uncertainty is an important aspect of investment. There is a trade-off between costs today and uncertain future gains. To understand how investment decisions are made, we need to learn about interest rates:To understand how investment decisions are made, we need to learn about interest rates: Nominal interest rates are rates quoted in the financial markets. Nominal interest rates are rates quoted in the financial markets. The real interest rate is the nominal interest rate minus the inflation rate. The real interest rate is the nominal interest rate minus the inflation rate.

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Volatility of Investment Spending John Maynard Keynes referred to the volatility of investment spending as “animal spirits.” This means that investment is a very volatile component of GDP.John Maynard Keynes referred to the volatility of investment spending as “animal spirits.” This means that investment is a very volatile component of GDP. The volatility of investment is associated with fluctuations in GDP. Projections of the future and investors’ decisions today are likely to move in conjunction with real GDP growth.The volatility of investment is associated with fluctuations in GDP. Projections of the future and investors’ decisions today are likely to move in conjunction with real GDP growth.

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Accelerator Theory The accelerator theory emphasizes the role of expected growth in real GDP on investment spending.The accelerator theory emphasizes the role of expected growth in real GDP on investment spending. When real GDP growth is expected to be high, firms anticipate that their investments in plant and equipment will be profitable and therefore increase their total investment spending.When real GDP growth is expected to be high, firms anticipate that their investments in plant and equipment will be profitable and therefore increase their total investment spending.

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Accelerator Theory In his multiplier-accelerator theory, Nobel laureate Paul Samuelson explained how a downturn in real GDP leads to a sharp fall in investment, which further reduces GDP through the multiplier for investment spending.In his multiplier-accelerator theory, Nobel laureate Paul Samuelson explained how a downturn in real GDP leads to a sharp fall in investment, which further reduces GDP through the multiplier for investment spending.

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment Spending as a Share of U.S. GDP, 1970-2000 As this figure shows, investment is highly procyclical.As this figure shows, investment is highly procyclical.

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Nominal Interest Rates and Real Interest Rates A bond is a promise to pay money in the future in exchange for money now.A bond is a promise to pay money in the future in exchange for money now. The cost of borrowing or lending money is different from the actual interest paid or received. Calculating the true cost of borrowing or lending involves the reality principle:The cost of borrowing or lending money is different from the actual interest paid or received. Calculating the true cost of borrowing or lending involves the reality principle: Reality PRINCIPLE What matters to people is the real value of money or income–its purchasing power–not the face value of money or income.

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Nominal and Real Interest Rates for Lenders and Borrowers Impact of Inflation for lenders Nominal interest rate 6% minus the inflation rate 4% = real rate of interest 2% Investor lends $100 Receives one year later ($100 x 1.06) $106 minus impact of inflation (100 x 0.04) -$4 = actual real gain $2 Individual borrows $100 pays back after one year ($100 x 1.1) $110 minus impact of inflation (100 x 0.06) -$6 = actual cost to borrower $4 Impact of Inflation for borrowers Nominal interest rate 10% minus the inflation rate 6% = real rate of interest 4%

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin A Variety of Interest Rates Riskier loans and loans for longer maturities typically have higher interest rates.Riskier loans and loans for longer maturities typically have higher interest rates.

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Expected Real Interest Rate Before individuals lend or borrow, they must form an expectation of the inflation rate in the future.Before individuals lend or borrow, they must form an expectation of the inflation rate in the future. For a given nominal interest rate, the expected real interest rate is the nominal interest rate minus the expected inflation rate.For a given nominal interest rate, the expected real interest rate is the nominal interest rate minus the expected inflation rate.

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Expected Real Rates of Interest (percent per year) Country 3-Month Interest Rate Inflation Rate Forecast for 2001 Expected Real Rate of Interest Australia4.943.601.34 Canada4.262.401.86 Denmark4.802.302.50 Switzerland3.251.202.05 United States 3.522.900.62

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment Spending and Interest Rates Here is an example of a typical investment:Here is an example of a typical investment: A firm can invest $100 today in a project and receive $104 one year from today. There is no inflation. Should the firm make this investment?A firm can invest $100 today in a project and receive $104 one year from today. There is no inflation. Should the firm make this investment?

15. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment Spending and Interest Rates The decision to invest is based on the principle of opportunity cost.The decision to invest is based on the principle of opportunity cost. The interest rate prevailing in the economy provides a measure of the opportunity cost of investment.The interest rate prevailing in the economy provides a measure of the opportunity cost of investment. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

16. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Investment Spending and Interest Rates A firm has a menu of investment projects it would like to undertake.A firm has a menu of investment projects it would like to undertake. If the net return from an investment exceeds the opportunity cost of the funds, the investment should be undertaken.If the net return from an investment exceeds the opportunity cost of the funds, the investment should be undertaken. As market interest rates rise, there will be fewer profitable investments.As market interest rates rise, there will be fewer profitable investments.

17. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Returns on Investment At a market interest rate of 2% per year, for example, only investment A is unprofitable. All the other investments have a return greater than the opportunity cost of the funds.At a market interest rate of 2% per year, for example, only investment A is unprofitable. All the other investments have a return greater than the opportunity cost of the funds. Investment Cost CostReturn A$100$101 B100103 C100105 D100107 E100109

18. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates and Investment There is a negative relationship between real investment spending and the real interest rate.There is a negative relationship between real investment spending and the real interest rate. As the real rate of interest rises, fewer investment projects will be profitable.As the real rate of interest rises, fewer investment projects will be profitable.

19. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates and Investment Remember, nominal rates of interest are not a good indicator of the true cost of investing.Remember, nominal rates of interest are not a good indicator of the true cost of investing. The firm makes its investment decisions by comparing the expected real net return from investment to the real rate of interest.The firm makes its investment decisions by comparing the expected real net return from investment to the real rate of interest.

20. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Neoclassical Theory of Investment The neoclassical theory of investment, pioneered by Dale Jorgenson of Harvard University, asserts that real interest rates and taxes play a key role in determining investment spending.The neoclassical theory of investment, pioneered by Dale Jorgenson of Harvard University, asserts that real interest rates and taxes play a key role in determining investment spending.

21. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Q-theory of Investment The Q-theory of investment, developed by Nobel laureate James Tobin of Yale University, links investment spending to stock prices. It states that investment spending increases when stock prices are high. Then, the firm uses its proceeds from the sale of stock to undertake new investment.The Q-theory of investment, developed by Nobel laureate James Tobin of Yale University, links investment spending to stock prices. It states that investment spending increases when stock prices are high. Then, the firm uses its proceeds from the sale of stock to undertake new investment.

22. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin How Financial Intermediation Facilitates Investment Financial intermediaries help bring savers and investors together. By using their expertise and the powers of diversification, financial intermediaries reduce risk to savers and allow investors to obtain funds on better terms.

23. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Financial Intermediaries

24. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Why Financial Intermediaries Emerge Households save for different reasons than firms invest.Households save for different reasons than firms invest. Households try to minimize risk and have their savings readily accessible, or liquid.Households try to minimize risk and have their savings readily accessible, or liquid. Firms are risk takers and need funds that will be tied up for a long time.Firms are risk takers and need funds that will be tied up for a long time.

25. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Why Financial Intermediaries Emerge By pooling the funds of savers and making loans to individual businesses, financial intermediaries reduce the costs of negotiation.By pooling the funds of savers and making loans to individual businesses, financial intermediaries reduce the costs of negotiation. They also acquire expertise in both evaluating and monitoring investments.They also acquire expertise in both evaluating and monitoring investments. Some financial intermediaries also provide the liquidity households demand.Some financial intermediaries also provide the liquidity households demand.

26. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Why Financial Intermediaries Emerge Financial intermediaries reduce risk through diversification. They invest in a large number of projects whose returns, although uncertain, are independent of one another.Financial intermediaries reduce risk through diversification. They invest in a large number of projects whose returns, although uncertain, are independent of one another. Every household has a small stake in many projects. Together, they can achieve the average return on investment with greater certainty than any single household can.Every household has a small stake in many projects. Together, they can achieve the average return on investment with greater certainty than any single household can.

27. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin When Financial Intermediation Malfunctions Important examples of failure in financial intermediation are:Important examples of failure in financial intermediation are: Commercial bank failures during the Great Depression. Commercial bank failures during the Great Depression. The savings and loan crisis of the 1980s in the United States. The savings and loan crisis of the 1980s in the United States. A similar crisis in Japan in the 1990s. A similar crisis in Japan in the 1990s.

28. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin When Financial Intermediation Malfunctions During the early days of the Great Depression, depositors worried that loans provided to farmers and local businesses would not be profitable.During the early days of the Great Depression, depositors worried that loans provided to farmers and local businesses would not be profitable. Rumors that banks would soon close their doors triggered “runs” on banks—all depositors panicking and rushing to withdraw their deposits simultaneously.Rumors that banks would soon close their doors triggered “runs” on banks—all depositors panicking and rushing to withdraw their deposits simultaneously.

29. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin When Financial Intermediation Malfunctions To prevent bank runs, the U.S. government began to provide deposit insurance for banks and savings and loans.To prevent bank runs, the U.S. government began to provide deposit insurance for banks and savings and loans. The government insures funds up to $100,000 even if the bank fails. Since everyone knows their deposits are secure, runs on banks no longer occur.The government insures funds up to $100,000 even if the bank fails. Since everyone knows their deposits are secure, runs on banks no longer occur.

30. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin When Financial Intermediation Malfunctions In the early 1970s, savings and loan institutions made mortgage loans at low interest rates. In the late 1970s, nominal interest rates rose sharply as inflation increased.In the early 1970s, savings and loan institutions made mortgage loans at low interest rates. In the late 1970s, nominal interest rates rose sharply as inflation increased. The savings and loans were in trouble: they had to pay high interest rates to attract deposits, but were earning low rates from their past investments. Many S&Ls went bankrupt.The savings and loans were in trouble: they had to pay high interest rates to attract deposits, but were earning low rates from their past investments. Many S&Ls went bankrupt.

31. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin When Financial Intermediation Malfunctions In the early 1980s, the government tried to assist the S&Ls by deregulating the industry and allowing the S&Ls to make investments other than housing.In the early 1980s, the government tried to assist the S&Ls by deregulating the industry and allowing the S&Ls to make investments other than housing. The S&Ls became aggressive investors in speculative real estate and other risky projects, and lost billions. Ultimately, taxpayers paid $100 billion to the S&Ls depositors for their (insured) savings.The S&Ls became aggressive investors in speculative real estate and other risky projects, and lost billions. Ultimately, taxpayers paid $100 billion to the S&Ls depositors for their (insured) savings. Japan suffered a similar crisis in the 1990s, at a cost to taxpayers of nearly 13 billion U.S. dollars to rescue companies and prevent further disruptions in the financial market.Japan suffered a similar crisis in the 1990s, at a cost to taxpayers of nearly 13 billion U.S. dollars to rescue companies and prevent further disruptions in the financial market.